Good move, Geithner

After seeing domestic Chinese leaders voice their acceptance of a stronger Yuan last week, I’m becoming convinced that Yuan appreciation is on the horizon. The next few months are so crucial that I got a bit nervous that Obama and Co. might miss a potentially great opportunity to work with the Chinese and get too aggressive in the April 15th “Semiannual Report on International Economics and Exchange Rate Policies”. They’ve seemed to take a general “long-view” approach on most of their agenda, but this probably is the issue where they can score the easiest domestic political points.

I was still fairly surprised by the Administration’s move this week. The Administration didn’t take the aggressive action of labeling China the first currency manipulator since 1994, nor did they ignore this issue that does need to be addressed in some manner. Instead, Geithner made a statement that they’ll delay the April 15th report to instead work to resolve the issue via three critical diplomatic forums over the next few months:

There are a series of very important high-level meetings over the next three months that will be critical to bringing about policies that will help create a stronger, more sustainable, and more balanced global economy. Those meetings include a G-20 Finance Ministers and Central Bank Governors meeting in Washington later this month, the Strategic and Economic Dialogue (S&ED) with China in May, and the G-20 Finance Ministers and Leaders meetings in June. I believe these meetings are the best avenue for advancing U.S. interests at this time.

Surplus economies with inflexible exchange rates should contribute to high and sustained global growth and rebalancing by combining policy efforts to strengthen domestic demand with greater exchange rate flexibility.

China knows that in the long run they need to shift to domestic-demand driven growth, and artificial CNY strength against the USD is only delaying this transition. This current system of Chinese exporters being subsidized by Chinese households/consumers, and US households being subsidized by a weaker US export/production sector cannot continue forever. Their leaders are speaking about the need for this major economic transition, and policy like their stimulus show concrete actions are being taken. It’s going to slowly happen, the question is just, how smooth will it go?

The good scenario: The weak CNY is effectively a trade subsidy for Chinese exporters who have been able to become kings of cost-competitive, low-margin, manufacturing export businesses. In a perfect world, the CNY would gradually strengthen until it could even be free-floating, while Chinese domestic demand would concurrently increase. The former export business leaders adapt to meet this rising demand by creating innovative, world-class businesses. End result: everyone is happy as the US regains some strength in their manufacturing and export businesses and the Chinese consumer fuels a new channel of long-term, stable, Silicon Valley-style Chinese growth. Wonderful!

The bad scenario: Chinese exporters rapidly lose their implicit subsidy through either a significant CNY revaluation or a trade war. These businesses have become somewhat dependent on this cost advantage and could shut down because they can’t compete any longer. Chinese unemployment rises as jobs leave the country, and any shot of having the future strong Chinese consumer that’s supposed to rebalance the global economy vanishes. Not Wonderful.

The scenarios outlined are definitely as oversimplified as the rhetoric that generally comes out of D.C., but the logic is simple. Both China and the U.S. know that we need to move away from the current system of Chinese manufacturers and exporters subsidizing US consumers. The issue is how we make this move and the stakes are what type of growth we will see in both hemispheres in the coming decades. It was a relief to see that Geithner and Gang are willing to take an extra few months to address this issue that has been brewing for years and directly engage Chinese officials. Chinese officials and leaders appear ready to resume the slow transition to a stronger CNY that began in 2005. Lindsey and Chuck, it’s going to happen so no need to get so worked up. Instead of lighting a fuse through some arcane report that the average American has never even heard of, I’m glad to see that these complex and crucial economic issues will be addressed at forums like the “Strategic & Economic Dialogue with China”.